Lecture 7Laws of Returns

Laws of Returns• There are three laws of returns known to

economists:

– Law of Diminishing Returns

– Law of Increasing Returns

– Law of Constant Returns

Law of Diminishing Returns• The law of diminishing returns (also called the Law of

Increasing Costs) is an important law of micro economics. • The law of diminishing returns states that:– "If an increasing amounts of a variable factor are applied to a

fixed quantity of other factors per unit of time, the increments in total output will first increase but beyond some point, it begins to decline".

• Richard A. Bilas describes the law of diminishing returns in the following words: – "If the input of one resource to other resources are held

constant, total product (output) will increase but beyond some point, the resulting output increases will become smaller and smaller”. 

Operation of Law of Diminishing Returns in Agriculture

• The classical economists were of the opinion that – the law of diminishing returns applies only to agriculture and to

some extractive industries, such as mining, fisheries urban land, etc.

• The law was first stated by a Scottish farmer as such. – It is the practical experience of every farmer that if he wishes to

raise a large quantity of food or other raw material requirements of the world from a particular piece of land, he cannot do so.

– He knows it fully that the producing capacity of the soil is limited and is subject to exhaustation.

– As he applies more and more units of labor to a given piece of land, the total produce no doubt increases but it increases at a diminishing rate.

ExampleFixed Input Inputs of Variable

ResourcesTotal Produce TP

(in tons)Marginal product

MP (in tons)

12 Acres 1Labor 50 50

12 Acres 2Labor 120 70

12 Acres 3Labor 180 60

12 Acres 4Labor 200 20

12 Acres 5Labor 200 0

12 Acres 6Labor 195 -5

Diagram

Laws of Variable Proportions• Law of Diminishing Returns is a misnomer (wrongly applied name)

• It is only the third stage of one of the basic law i.e. Law of variable proportions

• This law is also called Law of Proportionality

• This law tells us how the total output or marginal output is affected by a change in the proportion of the factors used

• Since, the return to the variable factor does not change at the same rate in all stages, it is also called the Law of Non-proportional Returns

Explanation of Law of VP• In production process, after a stage, the marginal return

begins to diminish– It is due to the technological facts underlying the production

of the product in question– Every industry has its own peculiar set of technical facts. For

example• Agriculture is dominated by the nature of land

– In agriculture, the MR starts diminishing early

• Manufacturing industry by capital– In industry, it starts diminishing very late– Which a wise entrepreneur can altogether avoid

• The Law of Variable Proportion occupies a very important place in economic theory – It describes the production function with one variable factor

while the quantities of other factors of production are fixed

Law of VP in words of Economists• In the word of Stigler– As equal increments of one input are added, the inputs of other

productive services being held constant, beyond a certain point the result in increment of product will decrease i.e. the MP will diminish

• Prof. Samuelson states– An increase in some inputs relative to other fixed inputs will, in a

given state of technology, cause output to increase; but after a point the extra output resulting from the same additions of extra inputs will become less and less

• Prof. Benham also states– As the proportion of one factor in a combination of factors is

increased, after a point, first the marginal and then the average product of that factor will diminish

Assumptions of the Law of VP

• State of Technology remains unaltered– It is obvious that improvements in technology are

bound to raise the MP and AP and they will not diminish

• Some inputs are kept constant– This law does not apply in case all inputs are variable

• Does not apply in the case of factors used in fixed proportions

Limitations of Law of DR• Improved methods of Cultivation– Scientific rotation of crops, improved seeds, better

irrigation facilities are bound to give increasing return

• New Soil– Virgin soil gives more yield. Later the return will diminish

• Insufficient Capital– If less capital in the beginning then first yeild will

increase– Beginning part is exception to the law

Why Law Applies to Agriculture?• The agricultural operations are spread out

over a wide area – Supervision cannot be effective

• Scope of use of specialized machinery is limited– Economies of large scale cannot be reaped

• Seasonal nature of the industry– Interrupted by rain and climatic changes

Why this law operates?• Wrong combination– In the initial stages, the fixed factor is not fully used since

the units of variable factor are too few• Hence, increase in variable factor is productive

– Then optimum combination– Further, increase counter productive

• Scarcity of Factors– The expansion of an industry, provided that additional

supplies of some agent in production, which is essential cannot be obtained

• Imperfect Substitutes– Factor of production are imperfect substitutes

Law of Increasing Returns• An industry is subject to the law of increasing

returns if – extra investment in the industry is followed by

more than proportionate returns e.g if the marginal product increases

• These two laws of increasing and diminishing returns can also be explained in terms of optimum business unit– Increasing returns when moving towards optimum – Diminishing returns when moving beyond optimum

Why Law of Increasing Returns Operates?

• No scarcity of factors– Law of diminishing returns operate when there is scarcity of

some factor. If there is no such scarcity then law of increasing returns will operate

• Right Combination– Law of diminishing returns operate when there is wrong

combination of factors of production when there is right combination of the factors law of increasing returns will apply

• Full use of Indivisible Factors– Plant may be setup to meet the higher demand so increasing

returns when more utilization

Law of Constant Returns• There can be a situation where neither law of

diminishing operates and nor law of increasing rates operate– Over there law of constant returns will operate

• An industry is subject to the law of constant returns when, – Whatever the output or scale of production, the

cost per unit remains unaltered, or – increased investment of labour and capital results

in a proportionate increase in the output.

Returns to Scale• Returns of scale is meant – the behaviour of production or returns – when all the productive factors are increased or

decreased simultanously– in the same ratio

• The returns to scale of production may clearly be distinguished from the law of variable proportions – In the law of variable proportions • Some factors are variable atleast one is constant

– In returns to scale • All the necessary factors of production are increased or

decreased to the same extent • So that whatever the scale of production, the proportion

among the factors remains the same

Three Phases of Returns to Scale • First Phase– With increase in scale of production returns increase

more than increase in scale of production

• Second Phase– Increase in returns proportionally increase with the

increase in scale of production

• Third Phase– Increase in return is, proportionally, less than increase

in scale of production